The LIQ Index
With millions of contracts changing hands every hour of the trading day, there’s always opportunity somewhere. The LIQ Index identifies where these shifts are happening - tighter markets, more volume, and open interest turning over.
Two sided quotes are streamed continuously throughout the day by dealers and market makers. Across a broad range of strikes and expirations there are a lot of prices to make sense of. The starting point for all of our indices is good data.
Unlike in equity markets where the closing print represents a highly liquid matching of significant volume, options markets tend to widen out at the end of the day, or display quotes that aren’t perfectly representative of a true value.
Very low and very high delta options are notorious for producing wonky values. It’s rather common to see a nearer to the money put quoted 0 - .10, while the further away strike is quoted 0-.05. Taking the midpoint, you’d see the far strike worth .05 while the near strike is .025. We know that’s not coherent. Deep in the money options have a similar problem, where wide markets yield erratic midpoints.
This can also have an impact on implied volatility calculations, where rounding and quote flickering produces differences in call and put values on the same line. Another practical reality, that isn’t theoretically possible.
To perform index calculations, we use a smoothed data set that adjusts for these edge cases and yields an arbitrage free curve of implied volatility.
With data in place, the first metric we analyze is the market width. Stocks have all different prices, and therefore a nickel wide market in a $10 stock is very different from a nickel wide market in the SPX. By using the implied volatility width, we normalize for spread width across the range of stocks. The implied volatility of the bid is subtracted from the ask, and averaged across calls and puts.
To get a representative sample of the stock’s liquidity, we focus on the near term and at the money options. Further out months and strikes away from the current price trade infrequently and are less influenced by changing levels of option supply and demand.
Tight spreads indicate a high confidence level in pricing, and are an expression of market liquidity. Dealers offer tight pricing when they themselves are confident in their ability to manage the position’s risk.
Volume is the artifact of buyers meeting sellers. This happens when two sides agree to a value and take opposite sides. Every buy and sell order will shift the pricing curve in some dimension. If there are more buyers of downside protection, the skew will steepen, just as sellers of implied volatility will shift the whole curve down.
The LIQ Index compares current volume with longer term averages to identify when these shifts are taking place.
Open Interest is what volume becomes the next day. This number is tracked on a per series basis, and indicates the total number of contracts that are outstanding, each with a long and short position.
With open positions, dealers are more likely to provide better pricing with the hopes of closing. Series that lack open interest will tend to see wider pricing because it represents a new position or risk taking in the marketplace.
With the LIQ Index, we track volume that is both opening and closing, to see which issues are seeing new volume, and which are seeing activity in existing positions.
Historical Context
Options market liquidity continues to grow over time, but it's not a straight path upward. Liquidity moves around more than asset or volatility prices. Market widths can change dramatically day over day, even in the most actively traded names.
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Below is a comparison of the LIQ Index in SPY compared to ATM Vol and underlying price. As you'll see, when volatility spikes there might be more volume, but market widths widen more dramatically to offset this. Some of the lowest readings of the last four years came during the early pandemic trading.
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Slower markets and seasonality also reduce liquidity, as less volume often means dealers will widen out their markets to compensate for additional risk.
